We both learned from the great Milton Friedman--Scott as one of his students, me indirectly as a student of two Friedman students, Ben Klein and Mike Darby, and from reading Milton's work and occasionally talking to him and corresponding with him.

One of the most valuable things Milton did was revive the quantity theory. It has its problems, but one virtue that remains is reminding us of the relationship MV = Py, where M is the money supply, V is the velocity of money, P is the price level, and y is real output (real GDP, in the current vernacular.)

Protectionism makes y, real GDP, lower than otherwise. Scott and I agree on that. With an unchanged M and unchanged V, P is higher than otherwise. Therefore an increase in protectionism causes an increase in P. We normally refer to an increase in P, the price level, as inflation.

Scott doesn't dispute that. What he argues is that the current Federal Reserve Board will offset any increase by adjusting monetary policy, M, keeping the inflation rate at or around 2%.

He may well be right, but that doesn't mean that protectionism is not inflationary. Protectionism IS inflationary AND the Fed can offset this inflation.

But what about Milton Friedman's famous line, "Inflation is always and everywhere a monetary phenomenon." You can regard that statement as tautological because inflation, by definition, is a reduction in the value of money. But Milton meant much more than that: he meant that every inflation we could point to was caused by an increase in the money supply. He was probably right, but that's an empirical statement, not a statement of necessity. He would not have disputed that a little change in inflation could be due to a change in the growth of real output; what he was saying was that every episode of inflation involved an increase in the money supply, not that there weren't other factors that made inflation, say, 2.2% instead of 2.0%.

One person who commented on Scott's post, Maurizio, put it well:

If you have protectionism and all other variables stays [sic] the same (and therefore the Fed does not do any offset), protectionism is inflationary. If you assume the Fed does the offset, then you are changing two variables at once.

Comments and Sharing

Suppose Y is a random variable, determined by a plethora of things such as technology, labor, capital, and government policy. The Fed directly controls M and V, which together determine P, given Y.

If something happens to change Y and the Fed doesn't do anything to change M or V, I don't think it's right to say that the change in Y caused the change in P.

You could imagine the Fed as a drawbridge operator whose job it is to raise the bridge when ships want to pass. If the Fed doesn't raise the bridge and a ship crashes into it, who's fault is it, the ship's or the Fed's?

I do not think that the idea of "all other variables staying the same" (in Maurizio's formulation) is as clear as you and Maurizio seem to think. Exactly what are these "other variables"? Of course, the price level itself is a "variable," so you will need to distinguish between basic and secondary (derived, dependent) variables, and say that the price level is secondary (and that you meant: "all other basic variables staying the same"). But what, exactly, are these basic variables?

Note that if the Fed's reaction function is counted as basic, Scott is right.

@Garrett M,
It’s not correct to state that the Fed controls V. It has a lot of control over M. If something happens to change Y and the Fed doesn't do anything to change M or V, I don't think it's right to say that the change in Y caused the change in P.
There’s where we differ.You could imagine the Fed as a drawbridge operator whose job it is to raise the bridge when ships want to pass. If the Fed doesn't raise the bridge and a ship crashes into it, who's fault is it, the ship's or the Fed's?
I wasn’t discussing the issue of fault; rather, I’m discussing the issue of causation.
@Philo,Exactly what are these "other variables"?
M and V.Note that if the Fed's reaction function is counted as basic, Scott is right.
Correct.

I don't think it's right to say that the change in Y caused the change in P.

It's not right, but not for the reason you're imagining. The cause of the change in P are individual changes in prices that make up the agreggated statistic P. The sense in which Y "causes" P to change in this case is in the sense that the shifts of supply and demand for individual goods that collectively are added up into Y has changed and thus the market clearing price for each good whose price is used to construct P has also changed.

Of course given the assumption that MV is fixed, if the quantity of goods exchanged decreases their average price must increase by mathematical necessity, simultaneously. But we know that in reality the changing of individual prices to their market clearing levels requires a process of entrepreneurial discovery. Which implies that the assumption of a strictly fixed MV which does not change during the discovery period, is in contradiction with an economy which is in any way dynamic in the amount of goods exchanged. In other words the assumption is actually artificial.

Scott would contend that the Fed is (or should be) always an active participant in the money supply, keeping inflation where it wants inflation in the presence of millions of endogenous and exogenous changes to real and nominal effects. A tariff is just another change to deal with. If inflation were to happen, the Fed would have caused it by failing to account for the change it in its active management.

Scott does tend to assume that the Fed is always getting its way. I think it makes more sense to look at the Fed as acting on a constrained objective function. The has a target for P and for (un)employment but is constrained not to reduce ST interest rates below zero, almost never to allow the inflation rate to exceed 2%, not to move ST interest rates "too much" at a time, not to do "too much" QE.

Scott believes that committing to a Py trend target would allow it to overcome the political constraints. I'd like to see the experiment, or even a commitment to a price level target but I'm not convinced that the commitment would necessarily relax the constraints. Perhaps only relaxing the political constraints on use of monetary policy instruments would permit the Fed to commit to a Py target.

Obviously if you assume that protectionism causes y to fall then the accounting identity MV = Py leads to the conclusion that protectionism is inflationary.

But i assume that advocates of protectionism believe that it causes y to rise not fall - otherwise why would they support it ? I think they probably think that when the economy is below full employment then tariffs on imports will boost demand for domestic good and cause output (y) to increase.

@Scott Sumner,
@Market Fiscalist,But i assume that advocates of protectionism believe that it causes y to rise not fall - otherwise why would they support it ?
I don’t know and I don’t need to know. All I need to know is that protectionism does indeed cause y to be lower than otherwise (not fall.)

You have not really proven anything with this post. You have just assumed your conclusion.

Protectionism makes y, real GDP, lower than otherwise. Scott and I agree on that. With an unchanged M and unchanged V, P is higher than otherwise.

We actually have no idea if any of this is true.

I highly doubt protectionism is inflationary, regardless of what the Fed does: The import component of the PCE is ~20%. Some prices will rise, some will not. Some may even decline (for example if foreigners stop buying real estate as foreign direct investment declines).

Businesses (and consumers) will respond to higher import prices through substitution or efficiency, same as they would any other input cost hike. Whether the higher prices pass through depends at each stage on price elasticities. Protectionism certainly has re-distributive effects, and may be welfare reducing for some people. But it's not at clear that y declines as consumers substitute, and unlikely to cause a *general* rise in prices.

@dwb,You have not really proven anything with this post. You have just assumed your conclusion.
I’m not assuming my conclusion. I’m assuming, for purposes of this analysis, that protectionism reduces real income. Then my conclusion follows. And, no, I am not proving that assumption because I don’t need to. A well-established literature in international trade concludes that protectionism reduces the real income of the country whose government imposes it unless the government is exploiting its monopsony power. So all I’m assuming is that there are not a lot of goods on which the U.S. government has sufficient monopsony power to offset the real income loss to U.S. residents on the goods on which it has no such power.

It seems to me that both professors are correct, protectionism increases the price level other things even, but in practice it is unlikely to happen much because the Fed won't keep other things even if faced with a significant move in the price level.

To add to the confusion, personally I don't consider a one-time shift in the price level, which seems to be the likely result of a one-time bout of protectionism, to be "inflation". Meaningful inflation always has been a continuing process year-over-year.

Professor Sumner has even said that inflation is a meaningless term. I wouldn't go that far, but it certainly is poorly defined in popular usage. There surely are major differences in the implications of changes in the price level resulting from demand shocks v supply shocks, one time shifts v continuous shifting, etc. Different terms are needed for these different things to prevent costly confusion (even at the Fed, circa 2008). I'm with him as to that.

And I'm with Professor Henderson that the bottom line is that the most important thing for a nation's economic welfare is real production and productivity (thus real income) not nominal wages and price levels. And since protectionism reduces real productivity (in an attempt to increase the nominal measures) it is bad.

A distinction without a difference.
Whether y declines depends on the breadth and nature of the protectionist measures and whether the economy (or specific industries targeted) are at full employment (or have substantial slack). Protectionist measures solely targeting blueberries or sugar are unlikely to be change y or be inflationary, supply is elastic in those industries.

And conversely, the removal of protectionist measures like protection of the sugar industry are unlikely to be deflationary. The value of sugar in your consumption basket is immaterial compared to the other costs.

And actually: The fact that some protectionist measures have little if any obvious macro effect is precisely why many protectionist measures like the ones protecting sugar continue to be reauthorized - very few people are affected, except a small but vocal lobby group.

Protectionism might be inflationary, under some circumstances (for example: full employment and implementation of broad protectionist measures), but this post does not show it, it assumes it. I am not advocating for protectionism, by the way.

And as far as the literature, it also underestimates the persistence and size of unemployment-related trade shocks.

'All I need to know is that protectionism does indeed cause y to be lower than otherwise'

Its easy to think of examples where this seems not to hold.

Suppose you produce 100apples and trade 50 of them for 50 bananas and consume 50 of each.

A tax is put on the import of bananas. This causes their apple price to go up. You then work harder and produce 110 apples, and trade 65 of them for 45 bananas. You now consume 45 apples and 45 bananas.

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